Wednesday, September 20, 2017

Narendra Modi's demonetization scheme, which involved the sudden cancellation of all ₹1000 and ₹500 rupee notes, was designed to hurt those in the underground economy who had stashed away large amounts of cash. But many smaller cash users got caught up in the blast radius. Has Indian behaviour surrounding cash changed? More specifically, what long-term impact has the painful demonetization process had, if any, on the population's preferences for holding cash?

Luckily for us, we have a great data set for evaluating this question: the supply of currency in circulation. If the propensity of Indians to hoard notes has changed, we'd expect to see a long-term reduction in currency outstanding relative to trend.

Before we take a look at the data, I want to make one point on the economics of paper money. The old phrase "cranking up the printing presses" is a bad one because it implies that central bankers play an active role in deciding the quantity of paper money in the economy—they don't, their role is purely passive. At any point in time the stock of paper money in circulation has been determined by the decisions of the public. If people feel they need more notes, they'll go to their bank and withdraw them, the bank in turn submitting a request to the central bank to provide more. The job of a central bank is a simple one: react to the public's desire by printing new notes, or—in the case of a decline in demand for paper currency—withdrawing them.

While the stock of notes is always a reflection of people's preferences, there are a few exceptions. If there is a sudden spike in the demand for banknotes, and the central bank's printers can't keep pace, the public's desire for more paper will be temporarily frustrated.

This frustration is exactly what occurred in India in the months after demonetization. A whopping 85% of the nation's notes were suddenly cancelled. Indians needed to get their hands on replacement notes in order to move back to their preferred holdings of cash, but the RBI didn't have the printing capacity to meet this demand. Lineups at banks and ATMs grew, and withdrawal limits were imposed, a sure indication that the quantity of paper rupees in circulation was not consistent with Indian's preferences.

With 315 days having passed since demonetization was announced, has the RBI finally caught up to the public's desired stock of cash? I'd argue that it has. If we go back to this post by James Wilson, he calculates that—given various assumptions about the number of presses brought on line and shifts per day—all demonetized ₹500 would be replaced by as early as mid-June and late as mid-September 2017. We have now passed the later of the two dates.

The second reason that I think the RBI has caught up to Indians' demand for cash is the return of the same sawtooth pattern in the weekly currency-in-circulation data that characterized the pre-demonetization period. See below:

While currency in circulation consistently grew from mid-December 2016 onward, consistent with a dearth of paper money, it finally had its first week-to-week drawdown in July 2017, followed by several since then. The Indian public would only have returned currency to their banks if their collective demand for currency was finally satiated. If there was still a structural deficiency in the supply of notes, they would have kept these notes in their wallets rather than bringing them in.

The point of all this is to show that current data on the stock of rupees represents the true preferences of Indians, not RBI printing constraints. So let's take a closer look at the data itself. Prior to demonetization, India's currency supply had been consistently growing at around 15% a year, as represented by the black trendline below. In September 2016, just two months before demonetization, Indians had collectively chosen to hold ₹17.5 trillion in cash (around US$272 billion).

If there has been no change in cash-holding behaviour then the pre-demonetization growth path of 15% should still be in effect. If so, from a post-demonetization low Indians would have rebuilt their cash holdings to a trend amount of ₹20 trillion today. Instead, currency in circulation clocks in at just ₹15.8 trillion, around ₹4.2 trillion (or US$65 billion) less then the counterfactual.

So demonetization has certainly modified the cash-using behaviour of Indians. Their fingers burned, they have decided to hold just 75% of what they would otherwise have in their wallets had demonetization never occurred. It remains to be seen if this is a one-time change in the level of currency in circulation or whether the 15% growth rate itself will be permanently modified. In other words, from this point on growth in cash can either continue to grow 15% from a lower base of ₹15.8 trillion, or a new rate of growth might emerge, say 5-10%. Demonetization will have been a more effective cudgel if it succeeded in changing the actual rate of growth, not just the level.

One wonders what filled the ₹4.2 trillion void. Has the cash-using public decided to hold a larger stock of state-sanctioned digital money (i.e. mobile money balances and bank accounts) or have they simply chosen to swap one form of anonymous "black money" for another (i.e. cash for gold, diamonds, real estate)? I've gathered some data showing that at least some of the gap is being filled by the former.

The above chart shows that the number of point-of-sale (POS) terminals installed has experienced a one-time shot to the arm after last fall's demonetization announcement.

The other two charts show that the value of POS transactions using debit and credit cards moved to a new and higher plateau, as did mobile wallet payments (like Paytm). It is notable that transactions using these methods are not returning to their previous levels (although this is from a relatively small base) indicating that these payments options weren't mere fill-ins during the cash shortage period, but have enjoyed a permanent increase in adoption. Given that these new forms of digital payment are doing much more "work" as media of exchange, it probably makes sense to assume that they have captured at least some of the substitution out of cash.

So demonetization has certainly changed Indians' attitudes to cash. They like the stuff a bit less than before and are holding fewer bills in their wallets. This change might seem like an inevitable one, but at the time demonetization was announced it was by no means certain that it would have any effect whatsoever on tastes for paper money. Whether these effects justify the whole affair is a much more complex question.

P.S. You can also tell a story in which demonetization caused a depression in India's informal economy, and since economic activity in this sector plunged people had less demand for notes. So contrary to everything I wrote above, a one time change in preferences for alternative forms of money over cash didn't occur--people simply need less of the stuff because there are fewer transactions to be made. I don't doubt that demonetization hurt the informal economy, but I am skeptical that it would have led to a 25% reduction in cash usage. I think the changing-of-tastes story explains the data better.

Wednesday, September 13, 2017

If the world had a single cauldron for mixing various monetary phenomena, it would be Zimbabwe. Over the last two decades, it has experienced pretty much everything that can happen to money, from hyperinflation to deflation, demonetization to remonetization, dollarization and de-dollarization, bank runs, bank walks, and more.

Adding to this mix, the Zimbabwe Industrial Index—an indicator of local stock prices—has recently gone parabolic, having more than tripled over the last twelve months. That's a good sign, right? Beware, these gains aren't real. As is often the case in Zimbabwe, the rise in stock prices is a purely monetary phenomenon.

Ever since the great Zimbabwean hyperinflation led to the domestic currency becoming worthless in 2008, U.S. dollars have served as the nation's currency and unit of account. However, Zimbabwe's central bank, the Reserve Bank of Zimbabwe (RBZ), has spent much of the last two or so years surreptitiously bringing a new parallel monetary unit into circulation. These new units, informally referred to as RTGS dollars, are a digital form of money, specifically a deposit held at the central bank. (I described them here).

At the outset, RTGS dollars were denominated in U.S. dollars and supposedly convertible into genuine U.S. banknotes. We now know these units were only masquerading as U.S. dollars. By early 2016, huge lineups began to appear outside banks as Zimbabweans unsuccessfully tried to convert their deposits into real U.S. cash. When conversions finally became possible it was only because the RBZ had introduced its own paper currency, a 'bond note', in late 2016. These bond notes were themselves supposed to be fully fungible with U.S. dollars thanks to a promise of 1:1 convertibility, at least if you believed the nation's central banker, but this has never been the case.

Over the last year a great redenomination has been occurring as all Zimbabwean prices—including that of ZSE-listed stocks—are shifted over from a genuine U.S. dollar standard to an RTGS dollars/bond note standard. Prior to 2016, if you sold a stock or received a dividend, you'd get U.S. dollars, or at least a pretty decent claim on the real thing. Now, you get RTGS dollars—which can only be cashed out into an equally dodgy parallel currency, bond notes.

The incredible 300% rise in the Zimbabwe Industrial Index is a reflection of the redenomination of stocks into an inferior monetary unit and that unit's continued deterioration. For instance, if you were willing to sell your shares of Delta Brewing for $10 prior to the redenomination, you'd only be willing to sell them at a much higher level post-redenomination, say $15, in order to adjust for the diminished purchasing power of the money you'll receive upon sale. RTGS dollars are not U.S. dollars. After adjusting the Zimbabwe Industrial Index for the decline in the value of the money in which stocks are denominated, things certainly wouldn't look as bullish as the chart above indicates.

What is the actual exchange rate between RTGS dollars/bond notes? We can get a pretty good idea by looking at the prices of dual-listed shares. The shares of Old Mutual, a global financial company, trade in both Harare and on the London Stock Exchange. See chart below, courtesy of Gareth on Twitter.

Old Mutual investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other. Arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse.

The ratio of the two Old Mutual listings (the green line above) provides us with the implicit exchange rate between genuine U.S. dollars and dollars held in Zimbabwe. In 2009 the two listings traded close to parity (i.e. around $2 each), which makes sense because Zimbabwe had dollarized by then, and dollars-in-Zimbabwe were fungible with regular dollars. From 2010 to 2016 the dollar-denominated price in London was above the price in Zimbabwe. This discrepancy may be due in part to the fact that Harare-listed Old Mutual shares aren't very liquid, so they suffer a liquidity discount. Another reason is that the authorities place a ceiling (i.e. fungibility limits) on the number of Old Mutual shares that can be deregistered from the Harare market and dropshipped into London. With all of the space under the ceiling having presumably been used up, it would have been impossible to arbitrage the difference between the two prices, the Harare counter falling to a permanent discount.

So the Old Mutual ratio was probably not a good indicator of the implicit exchange rate between 2010 and 2016. However, in June 2016 this ceiling was raised, at which point arbitrage would have once again been possible. As such, the ratio would have probably returned to providing a decent indicator of the exchange rate between a dollar-in-Zimbabwe and a genuine dollar.

You can see that Old Mutual is currently valued at $5.80 in Zimbabwe whereas it only trades in London for around $2.66 per share (after converting from pounds into US dollars). This means that Zimbabweans are willing to put $5.80 in one end of the sausage maker in order to get $2.66 out from the other. So a dollar-in-Zimbabwe, which was trading at par to U.S. dollars just two years ago, is now worth just 46 cents. That's quite the inflation rate. I don't see things slowing down, either.

P.S.: Some investors will no doubt want to say the same thing is going on with the US and Europe with loose monetary policy creating so-called asset price inflation. I disagree.

P.P.S: Gareth has provided another chart. It shows the implied exchange rate between dollars-in-Zimbabwe and genuine U.S. dollars using the only other fully transferable dual-listed counter, PPC, a cement company that is also listed in Johannesburg. Note how close the PPC rate follows the Old Mutual rate.

Tuesday, September 5, 2017

Data on the world's biggest monetary event of the 21st century—Narendra Modi's demonetization—continues to trickle in. The Reserve Bank of India's just published its annual report (pdf) and I'll just say this straight out—I'm genuinely surprised. Out of the ₹15.44 trillion in paper currency that was demonetized by Modi last November, ₹15.28 trillion, or 98.96%, have been returned. My guess would have been that a much smaller proportion of India's monetary stock made it back to the RBI, maybe 92-95%.

For those not familiar with rupee prices, I'll translate the above numbers into US dollar terms. Back on November 9, 2016, $240 billion worth of rupee notes were declared to be invalid. By June 2017, only a small 1.04% sliver of this—$2.5 billion—was still unredeemed, far less than the $15-30 billion many of us though would have been left stranded. (I'll use dollars from here on since it is easier for the international community to understand.)

A glance at the stranded notes counts from a the euro changeover provides some context. When the Euro was introduced in January 2002, people were given fixed windows of time to redeem existing national banknotes before their money status was revoked. In the case of the Italian lira and French franc, individuals had till December 2011 and February 2012 respectively to bring in their notes for euros. By the time this ten-year exchange period was over, 99.15% of Italian lira had been returned while 98.77% of French francs made it back. Much of the unreturned 1% would have been withheld by the collecting community, the rest either being lost, buried, burnt in fires, or destroyed in floods.

Whereas the French and Italians had years to diligently round up old notes before the window closed, Indians only had few weeks, the final day for exchanging being December 31, 2016. Yet even with this much smaller window, Indians were able to bring in greater portion of the outstanding money supply than the French did in ten years. Impressive. Are Indians just great at locating things? Or is something else to explain? The skeptic in me wonders how many counterfeit rupees managed to make it passed the RBI's gatekeepers. No central bank can perfectly screen for fakes—so if the RBI mistakenly accepted a greater proportion of counterfeits than the Bank of France did, then the return rate on rupees would have been artificially improved relative to that of francs. But I'm just speculating.

What makes the final 98.96% return rate even more incredible is that, unlike the European demonetizations—which allowed unlimited, no questions-answered redemption—the Indian demonetization imposed per-person ceilings on the amount of rupees that could be freely converted into new paper rupees. Anything above the ceiling had to be deposited into a bank account i.e. individuals would be de-anonymized and potentially investigated. Yet even with the imposition of such a severe threat, a greater portion of rupees were redeemed in the waning days of 2016 than French francs during the entire 2002-2012 period.

Jugaad, or Indian ingenuity, is one of the explaining factors. Even though they had just a few weeks, Indians who had large quantities of illicit cash were able to contract with those who had room below their ceiling to convert illicit rupees on their behalf, thus evading Modi's blockade. This was money laundering on a grand scale.

There is a second explaining factor for the high return rate. Two weeks after the initial demonetization announcement, the government introduced a formal amnesty for demonetized banknote holders. Any deposit of cash above the ceiling would only be taxed at 50%, assuming it was declared. If not declared, the funds might still get through the note blockade undetected, although if apprehended an 85% penalty was to be levied. These new options were better than throwing away one's stash altogether and suffering a sure 100% loss, so previously reticent citizens would have flocked to bring their notes in, even if they had been amassed illicitly.

---

Demonetization was designed to provide a "national dividend" of sorts. If just 90% of the demonetized rupees had made it back to the central bank, the remaining
10% would have been written off, the one-time profit
providing a massive $24 billion dividend to all Indians (participants in the underground economy being the folks who funded this subsidy). Does the higher-than-expected 98.96% return rate for rupees mean that Modi's demonetization has failed as a mechanism for redistributing funds from large participants in the underground economy to the rest of the Indian population? Is the national dividend void? Not at all.

As I wrote above, many of the demonetized rupees that have made their way back into the system were deposited into bank accounts. Some depositors will have sought shelter under the 50% amnesty. For the remainder, authorities will be following the paper trails left by deposited currency over the next few years and, if warranted, levy a tax on these deposits. This is a more cumbersome way to collect a tax than stranding banknotes because it requires investigating each suspicious deposit and potentially prosecuting the depositor. It remains to be seen how successful the Indian authorities will be in collecting this tax. Jagdish Bhagwati explains this all in far more detail here.

Remember the ingenuity that Indians used to escape the ceilings that were imposed on them? This was also a form of redistribution. Rich Indians would have paid poor Indians—who had plenty of room under the ceiling—a fee to deposit notes on their behalf, say 25%, or ₹250 on a ₹1000
note. Together, all of these fees would be very much like the national dividend described in the above paragraphs. Except rather than the tax being collected by the authorities and then paid out as a
dividend, it would have been collected directly by Indians themselves. If
$25 billion was laundered in this way, and an average fee of 25%
charged, a $6.25 billion dividend would have been collected by poor
Indians from rich ones.

In summary, a large chunk of stranded rupee notes would have provided the 'cleanest' way of taxing to fund the national dividend. However, the fact that very few notes were stranded doesn't mean there will be no national dividend whatsoever.

Monday, August 28, 2017

One of the world's most notorious cases of counterfeiting was the 1925 Portuguese banknote crisis, when Artur Virgilio Alves Reis managed to pass off 200,000 fake five-hundred escudo notes, worth around £56 million in 2016 terms. When the Bank of Portugal discovered the counterfeits in December 1925, it announced an aggressive demonetization of the five-hundred escudo note, giving citizens just twenty days to bring in old notes for redemption. By then, the damage had been done. Reis had managed to increase Portugal's supply of banknotes by 5.9%, spending the equivalent of 0.88% of Portugal's nominal GDP into circulation! (More here.)

An aggressive note demonetization in the face of large-scale counterfeiting is a thoroughly justified response as it immediately puts a halt to the problem. In this context, it's worth revisiting the world's most recent attempt to combat counterfeiting with an aggressive demonetization—India PM Narendra Modi's forced recall of the Rs1000 and 500 notes on November 9, 2016, some 290 days ago. How does it compare to Portugal in 1925?

If we go back to Modi's initial speech, India's demonetization was targeted at the three "festering sores" of corruption, black money, and terrorism. On the latter, Modi said:

Terrorism is a frightening threat. So many have lost their lives because of it. But have you ever thought about how these terrorists get their money? Enemies from across the border run their operations using fake currency notes. This has been going on for years. Many times, those using fake 500 and 1,000 rupee notes have been caught and many such notes have been seized.

Given Modi's fighting words, we'd expect the demonetization to have caught quite a bit of bad currency. Last month, finance minister Arun Jaitley revealed how many counterfeit notes had been detected:

Translating Rs11.23 crore into dollar terms, the monetary authorities have found just US$1.7 million worth of counterfeit notes. Step back for a moment and compare $1.7 million to the full breadth and width of the demonetization. In declaring that all Rs1000 and 500 notes were to be useless, Modi demonetized US$240 billion worth of paper rupees, around 85% of India's stock of banknotes. So only 0.001% of the entire face value that has been brought in for conversion was fake! That's an incredibly low value of counterfeits, especially when you consider that in 1925, Reis's counterfeits accounted for around 5% of the entire Portuguese paper money supply.

Central bankers usually measure counterfeiting in parts per million, or PPM, the number of fakes detected in one year for every one million genuine notes in circulation. I've inserted a chart below, which comes from this Reserve Bank of Australia document. Canada, for instance, once had a much higher PPM (it even hit 450 back in 2004), but the Bank of Canada managed to bring this down to the low double digits by introducing new security features and, later, polymer notes.

Australia, the first nation to introduce polymer notes in the early 1990s, used to boast one of the lowest incidences of counterfeiting (below 5 PPM). Criminals are finally starting to make polymer fakes, perhaps because the RBA hasn't bothered to update the series for over two decades, giving plenty of time for counterfeiters to catch up.

In India's case, the recent numbers show a total of 158,000 fake notes detected (out of a 24 billion banknotes demonetized) between November 8, 2016 and July 14, 2017, this totaling up to a minuscule 6.6 PPM—in the same range of countries like Canada or Australia. And certainly not in the same category as Portugal in 1925.

Nor is this data anomalous. Back in January, James Wilson—an Indian civil engineer-turned-demonetization expert—perused official banknote statistics only to find that over the last few years India has not had a high incidence of counterfeit rupees, leading him to describe the demonetization effort as a cannon shooting at sparrows. Using some of the data from James' post, it's possible to calculate that India had a PPM of 7.1 in 2015/16. (I get this from 90.266 billion units of currency in circulation, and 632,926 counterfeits detected that year). This is consistent with earlier data from the Reserve Bank of India showing a PPM from 2007-2012 ranging between 4.4 to 8.1. So India's rate of counterfeits detected is fairly reasonable relative to other countries.

This low PPM could be due to two factors. Either India doesn't have a counterfeiting problem, or it does have one but the authorities are just really bad at detecting counterfeits. If neither Indian banks nor its central bank are particularly good at identifying fake notes, then a large stock of unidentified fakes may be permanently circulating along with legitimate banknotes with no one capable of draining out the fakes. But even so, why instigate a massive note recall to catch counterfeits if the institutions that do the catching are so leaky to start with? If it is the case that India has a counterfeiting problem, then Modi's go-to fixes should have been to improve note security features and the banking system's ability to detect fakes, not implement a massive Portuguese-style recall.

So the data certainly destroys one of the pillars on which Modi's demonetization was based; terrorism and fake currency. You need something like a Portugal in 1925 to justify an aggressive demonetization, and India wasn't even close. Over the next few months more data will pour in, expect Modi's scheme to be further tested.

Tuesday, August 22, 2017

The recent bitcoin chain split got me thinking again about bitcoin-as-money, specifically as a unit of account. If bitcoin were to serve as a major pricing unit for commerce on the internet, we'd have to get used to some very strange macroeconomic effects every time a chain split occurred. In this post I investigate what this would look like.

While true believers claim that bitcoin's destiny is to replace the U.S. dollar, bitcoin has a long way to go. For one, it hasn't yet become a generally-accepted medium of exchange. People who own it are too afraid to spend it lest they miss out on the next boom in its price, and would-be recipients are too shy to accept it given its incredible volatility. So usage of bitcoin has been confined to a very narrow range of transactions.

But let's say that down the road bitcoin does become a generally-accepted medium of exchange. The next stage to becoming a full fledged currency like the U.S. dollar involves becoming a unit of account—and here things get down right odd.

A unit of account is the sign, or unit, used to express prices. When merchants set prices in a given unit of account, they tend to keep these prices sticky for a while. A few of the world's major units of account include the $, £, €, and ¥. These units of account are conventional ones because there is an underlying physical or digital token that represents them. The $, for instance, is twinned with a set of paper banknotes issued by the Federal Reserve, while ¥ is defined by the Bank of Japan's paper media. Unconventional units of account do not have underlying tokens, but I'll get to these later.

So let's go ahead and imagine that bitcoin had succeeded in becoming the unit of account on the internet. The most commonly heard complaint of bitcoin-as-unit of account—a bitcoin standard so to say—is that it would be inflexible, more so than even the gold standard. It would certainly be more volatile, since the supply of bitcoin—unlike gold—can't be increased in response to prices. And those are fair criticisms. But there's a less-talked about drawback of a bitcoin standard: when a chain split occurs, all sorts of confusing things begin to happen that wouldn't occur in a conventional monetary system.

For those not following the cryptocurrency market, a chain split is when a new cryptocurrency is created by piggy-backing off an existing cryptocurrency's record of transactions, or blockchain, thus creating two blockchains. Luckily for us, a bitcoin chain split occurred earlier this month and provides us with some grist for our analytical mill. On August 1, 2017 anyone who owned some bitcoins suddenly found that not only did they own the same quantity of bitcoins as they did on July 31, but they had been gifted an equal number of "bonus" tokens called Bitcoin Cash, henceforth BCH. Both cryptocurrencies share the same transaction history up till July 31, but all subsequent blocks of transaction added since then have been unique to each chain.

This doesn't seem to be a one-off event. Having just passed through a split this August it is likely that Bitcoin will undergo another one in November. The history of Bitcoin is starting to resemble that of Christianity; a series of contentious schisms leading to new offshoots, more schisms, and more offshoots:

Here's the problem with chain splits. Say that you are a retailer who sells Toyotas using bitcoin, or BTC, as your unit of account. You set your price at 10 BTC. And then a chain split occurs. Now everyone who comes into your shop holds not only x BTC but also x units of Bitcoin Cash. How will your set your prices post-split?

The most interesting thing here is that an old bitcoin is not the same thing as a new bitcoin. Old bitcoins contained the entire value of Bitcoin Cash in them. After all, the August 1st chain split was telegraphed many months ahead—so everyone who held a few bitcoins knew well in advance that they would be getting a bonus of Bitcoin Cash. Because a pre-split price for the soon-to-be tokens of $300ish had been established in a futures market, people even knew the approximate value of that bonus. This anticipated value would have been "baked into" the current price of bitcoins, as Jian Li explain here. Then, once the split had occurred and Bitcoin Cash had officially diverged from the parent Bitcoin chain, the price of bitcoins would have fallen since they no longer contained an implicit right to get new Bitcoin Cash tokens.

Thus, BTCa = BTCb + BCH, or old bitcoins equals the combined value of new bitcoins and Bitcoin Cash.*

As a Toyota salesperson, you'd want to preserve your margins throughout the entire splitting process. In the post-split world, if you continue to accept 10 BTC per Toyota you'll actually be making less than before. After all, if one BTC is worth ten BCH in the market, then a post-split bitcoin—which is no longer impregnated with a unit of BCH—is worth just nine-tenths of a pre-split bitcoin. In real terms, your income is 10% less than what is was pre-split.

You have two options for maintaining your relative position. Option A is to continue to price in current BTC, but jack up your sticker price by 10% to 11 BTC. Customers will now owe you more bitcoins per Toyota, but this only counterbalances the fact that the bitcoins you're getting no longer have valuable BCH baked into them.

This would make for quite an odd monetary system relative to the one we have now. If everyone does the same thing that you do—mark up their sticker prices the moment a split occurs—the economy-wide consumer price level will experience a one-time shot of inflation. Given that bitcoin schisms will probably occur every few years or so, the long-term price level would be characterized by a series of sudden price bursts, the size depending on how valuable the new token is. When splits are extremely contentious, and the new token is worth just a shade less than the existing bitcoin token, the price level will have to double overnight. That's quite an adjustment!

We don't get these sorts of inflationary spasms in modern monetary systems because there is no precise analogy to a chain split. When August 1st rolled around, Bitcoin supporters could not invoke a set of laws to prevent Bitcoin Cash from being created on top of the legacy blockchain. In fiat land, however, a set of actors cannot simply "fork" the Canadian dollar or the Chinese yuan and get off scot-free. The authorities will invoke anti-counterfeiting laws, which come with very heavy jail sentences.**

The closest we get to chain splits in the real world are when the monetary authorities decide to undergo note redenominations. Central bankers in economies experiencing high inflation will sometimes call in—say—all $1,000,000 banknotes and replace them with $10 banknotes. And to compensate for this lopping-off of zeroes, merchants will chop price by 99.999% overnight. But redenominations are very rare, especially in developed countries. Up until it dollarized in 2008, even Zimbabwe only experienced three of them. Under a bitcoin standard, they'd be regular events.

Option B for preserving your relative position is to keep a sticker price of 10 per Toyota, but to update your shop's policy to indicate that your unit of account is BTCa, or old bitcoin, not new bitcoin. Old bitcoin is just an abstract concept, an idea. After all, with the split having been completed, bitcoins with BCH "baked in" do not actually exist anymore. But an implicit old bitcoin price can still be inferred from market exchange rates. When a customer wants to buy a Toyota, they will have to look up the exchange rate between BTCa and new bitcoin (i.e BTCb), and then offer to pay the correct amount of BTCb.

To buy a Toyota that is priced at 10 BTCa, your customer will have to transfer you 10 new bitcoins plus the market value of ten BCH tokens (i.e. 1 bitcoin), for a total price of 11 bitcoins. This effectively synthesizes the amount you would have received pre-split. As the market price of Bitcoin Cash ebbs and flows, your BTCa sticker price stays constant—but your customer will have to pay you either more or less BTCb to settle the deal.

The idea of adopting a unit of account that has no underlying physical or digital token might sound odd, but it isn't without precedent. As I pointed out earlier in this post, our world is characterized by both conventional units of account like the yen or euro and unconventional units of account. Take the Haitian dollar, which is used by Haitians to communicate prices. There is no underlying Haitian dollar monetary instrument. Once a Haitian merchant and her customer have decided on the Haitian dollar price for something, they settle the exchange using an entirely different instrument, the Haitian gourde. The gourde is an actual monetary instrument issued by the nation's central bank that comes in the form of banknotes and coins.***

So in Haiti, the nation's unit of account—the Haitian dollar—and its medium of exchange—the gourde—have effectively been separated from each other. (In my recent post on Dictionary Money, I spotlighted some other examples of this phenomenon.) An even better example of separation between medium and unit is medieval ghost money. According to John Munro (link below), a ghost money was a "once highly favoured coin of the past that no longer circulated." Because these ghost monies had an unchanging amount of gold in them, people preferred to set prices in them rather than new, and lighter, coins, even though the ghost coins had long since ceased to exist.

Unlike option A, which would be characterized by a series of inflationary blips each time a split occurred, option B provides a relatively flat price level over time. After all, the old bitcoin price of goods and services stays constant through each split. However, as the series of chain splits grows, the calculation for determining the amount of new bitcoins inherent in an old bitcoin would get lengthier. In the example above, I showed how to calculate how many bitcoins to use after just one chain split. But after ten or eleven splits, that calculation gets downright cumbersome.

Whether option A or B is adopted, or some mish-mash of the two, a bitcoin standard would be an awkward thing, the economy being thrown into an uproar every time a chain schism occurs as millions of economic actors madly reformat their sticker prices in order to preserve the real value of payments. If bitcoin is to take its place as money, it is likely that it will have to cede the vital unit of account function to good old non-splittable U.S. dollars, yen, and other central bank fiat units. The Bitcoin community is just too sectarian to be trusted with the task of ensuring that the ruler we all use for measuring prices stays more or less steady.

P.S.: I've focusing on sticker prices here, I haven't even touched on contracts denominated in bitcoin units of account. For instance, if I pay 10 BTC per month in rent for my apartment, what do I owe after a split? Ten old bitcoins? Ten new bitcoins? Or would I have to transfer 10 new bitcoin along with 10 units of Bitcoin Cash? Who determines this? What about salaries? The problem of contracts isn't merely theoretical, it actually popped up in the recent split as some confusion emerged on how to deal with to bitcoin-denominated debts used to fund short sales. Matt Levine investigated this here.

*There is also the complicating fact that the price of bitcoin didn't seem to fall by the price of Bitcoin Cash, thus contradicting the formula. As Matt Levine recounts:

In a spinoff, you'd expect the original company's value to drop by roughly the value of the spun-off company, which after all it doesn't own any more. 5 BCH spun off from BTC on Tuesday afternoon, and briefly traded over $700 on Wednesday (though it later fell significantly). But BTC hasn't really lost any value since the spinoff, still trading at about $2,700. So just before the spinoff, if you had a bitcoin, you had a bitcoin worth about $2,700. Now, you have a BTC worth about $2,700, and also a BCH worth as much as $700. It's weird free money, if you owned bitcoins yesterday.

**Say
counterfeiters do manage to create a large amount of fakes. Even then this
"fiat split" would have no effect on the value of genuine notes. Central
bank are obligated to uphold the purchasing power of their note issue.
They will filter out fakes be refusing to repurchase them with assets,
the purchasing power of counterfeits quickly falling to zero, or at
least to a large discount. When central banks are fooled by counterfeits
they will use up their stock of assets as they erroneously repurchase fakes. But even
then they will never lose the ability to uphold the value of banknotes
as long as the government backs them up with transfers of tax revenues.
Fiat chain splits only begin to have the same sort of effects as
bitcoin chain splits when 1) counterfeiting goes unpunished; 2) the central
bank can't tell the difference between which notes are genuine and which
are fakes; and 3) it lacks the firepower and government support necessary
to buy back paper money in sufficient quantity. Only at this point will counterfeiters succeed in driving the economy's price level higher.This, by the way, is what the Somali shilling looks like... a fiat currency constantly undergoing chain splits.

*** I get my information on Haiti from this excellent paper by Frederico Neiburg.

Thursday, August 10, 2017

The UK's recently-introduced one pound coin is made of 8.75 grams of metal, 76% of that copper and the remaining 24% a combination of zinc and nickel. At market prices, this amount of metal is worth around four pennies. So why do pounds trade for 100 pennies? Why are Brits passing these coins around as tokens—i.e. far above their metal content—rather than at their intrinsic melt value of four pennies each?

One answer is tradition. Brits accept that pound coins should trade at a 2000% premium to their metallic content because they've always done so. This isn't a very satisfactory answer. We need an explanation for why this tradition emerged in the first place.

It could be that the British government simply says that coins must be worth more than their metallic content, and Brits have fallen in line with this order. If they pass on these tokens at an illegal price, they'll be fined, or thrown in prison, or forced to drink tea without crumpets.

This too is an unsatisfactory explanation. Coin and banknote payments are highly decentralized—it's simply not possible to police against trades that deviate from the stipulated price. We have centuries of examples in which government proclamations about currency exchange rates have been ignored. Just today I can mention two. The Venezuelan government's official price for the bolivar is 2,870 to the dollar, but bolivars trade unofficially at 13,077, despite jail sentences to anyone caught trading in the black market. Zimbabwe's leaders say that their recently-printed issue of bond notes must trade at par to U.S. dollars, but in practice a 10-15% discount has emerged, one this will probably only widen over time.

So if governments can't will a monetary instrument like a coin to trade at a premium, where do these premia come from?

A bit of history about token coins—i.e. coins that carry a large premium—may help.

One strange feature about the world before the 1800s is that everyone—you, me, and our grandmas—had access to the mint. We could walk into the mint with a bag full of raw gold or silver and ask the mint master to have this material coined. Upon leaving we'd be provided with the same weight of metal (less a small fee for the mint), except that it had been transformed into coin form. This was called free minting: access was available to everyone.

Free minting meant that coins couldn't carry a premium over raw metal value, at least not for long. To see why, imagine a coin that contains one ounce of silver. When demand for that coin suddenly shoots up a shortage develops, the coin developing a 'fiat component'—it starts to trade at a large premium to its silver content, say one coin can buy two ounces of silver. At this point it has become a token. If I had one of these coins in my pocket, I'd sell it for two ounces of silver, take that silver to the mint, and get two coins in return. Voila, I've turned one coin into two coins! Because many people would conduct this same arbitrage, a slew of coins would enter into circulation. The shortage resolved, the market price of the coin would return to its intrinsic value. With the coin's fiat component gone, it has ceased to be a token.

If coins to are exist permanently as tokens, free minting needs to be halted. If people can't bring in silver to be minted, there is no way for the public to draw out a new supply of coins to remedy a shortage. It is then possible for a coin's value to have a permanent fiat component, or, put differently, for the coin's market price to forever above the intrinsic value of its metal content.

As an economy grows, people need more coins to conduct transactions. With the mints being shut to the public, how would this supply be created? The answer is that government itself must introduce new coins into circulation by purchasing metal, bringing it to the mint to be coined, and issuing the coins into the economy. If it puts too many coins into circulation, the artificial scarcity that feeds the fiat component of a coin's value will cease to exist and the price of these tokens will fall to their intrinsic melt value. By carefully regulating this supply, coins should always contain a fiat component—their token nature continuing in perpetuity.

These were precisely the steps taken by the British authorities when they introduced their first official issue of silver token coins in 1817. In the centuries before, the British monetary authorities had always maintained a policy of free minting of silver, the Royal Mint—owned by the government—producing only full bodied silver coins, not mere tokens. In 1817, the era of free minting was suddenly brought to an end. The Mint would now only make new coins for the government's account, not for the public. At the same time a token coinage was introduced, the silver content of the new coins being set such that it was now significantly below the coin's face, or par, value. The crown in the picture below, which has the legend of Saint George and the Dragon engraved on it, is an example of one of these early tokens.

To maintain the premium on its tokens, the Mint began to carefully regulate the supply of new coins. Here is monetary historian Angela Redish:

The Mint bought silver at the prevailing market price in the quantity it thought necessary and believed that by limiting the quantity of silver coin supplied it could maintain the value of the coins above the value of their silver content; that is, the supply limitation would give value to the fiat component of the currency. (pdf)

While this worked at first, over the next decade the mechanism for maintaining an artificial shortage—and thus the fiat component of the government's new tokens—broke down. From Redish, we learn that throughout the 1820s the new tokens began to accumulate at the Bank of England, still then a private bank, which had a policy of accepting tokens at their official value from the public, providing gold in return. (The Mint itself had no conversion policy.) The Bank had effectively become the only redemption agent for government tokens. Without the Bank's sopping up the public's unwanted supply at par, the market value of silver tokens would have quickly become unhinged from the coin's face value, eventually falling in price to the market value of their metal content.

Having the Bank of England act as the lone redemption agent for the government's token coins wouldn't do, so in 1833 the government officially took on the task of maintaining the par value of tokens. The Bank of England still accepted all silver coins from the public at par, but now the Bank was allowed to return this stockpile to the Mint for redemption in gold at the coin's par value.

And that, ladies and gentleman, is why your new pound coins, despite containing just 4 pennies in metal content, are worth a full pound. Since 1833 the British Treasury has promised to act as a backstop for all its token coinage, buying them back at their full face value so as to prevent any decline in the fiat component of its coins. Put differently, your one pound coin is worth 2400% more then its metal content because the government promises to uphold that premium by using funds it has raised out of tax revenue.

Coins are thus very much a liability or IOU of the government. This IOU nature of coins tends to operate far in the background, but it becomes much more apparent when a denomination of coins is cancelled. Take for instance the 2013 termination of the Canadian cent, in which the Royal Canadian Mint began to withdraw the lowly penny, the nickel being given the duty of serving as our nation's smallest denomination coin. Ever since then Canadians have been dutifully bringing their hoard of pennies into the local bank in return for cash or a credit to their bank accounts, banks in return sending the coins onward to the government for redemption.

We know from its initial report that the government budgeted $53.3 million to pay the face value of pennies redeemed. Which means that it anticipated the return of 5.3 billion pennies. According to the Mint's 2016 Annual Report, some 6.3 billion pennies have been since brought in, a small amount compared to the roughly 35 billion produced since 1908 and presumably still languishing under mattresses and in dumps—but still above the budgeted amount. Which means a larger chunk of Canadian taxes will have to go to paying penny IOUs then originally expected.

So as you can see, it isn't by mere diktat or tradition that coins trade above their metal content. It's the government's promise to buy them back that provides coins with their fiat component. In the case of the UK's new one pound tokens, should Her Majesty's Treasury refuse to backstop them its quite probably they'd be worth, say, just 90 pence a few years from now; 50 pence a decade hence; and finally 4-5 pence much further down the road. The market value of the pound coins wouldn't fall below that. At 2 or 3 pence per coin, Brits would start withdrawing them from circulation and illegally melting them down for their metal value.

To write this post, I relied on these two fine sources:1. Angela Redish, The Evolution of the Gold Standard in England, pdf2. George Selgin, Good Money, link

I also got inspiration from the conversation with Dinero and Antti on this post.

Tuesday, July 25, 2017

Now that the U.S. debt ceiling season is upon us again, I've been wondering if the U.S.'s official gold price is going to finally be revalued from $42.22. Why so?

Since March the U.S. Treasury has been legally prohibited from issuing new debt. Because the government needs to continue spending in order to keep the country running, and with debt financing no longer an option (at least until the ceiling is raised), Treasury Secretary Mnuchin has had no choice but to resort to a number of creative "extraordinary measures," or accounting tricks, to keep the doors open. Here is a list. They are the same tricks that Obama used in his brushes with the debt ceiling in 2011 and 2013.

The general gist of these measures goes something like this: a number of government trusts and savings plans invest in short term government securities, and these count against the debt limit. As these securities mature they are typically reinvested (i.e rolled over). The trick is to neither roll these securities over nor redeem them with cash. Instead, the assets are held in a limbo of sorts in which they don't collect interest—and no longer count against the debt limit. This frees up a limited amount of headroom under the ceiling that the Treasury can fill with fresh debt in order to keep the government functioning.

These tricks provide around $250-300 billion of ammunition. Which sounds like a lot, but in the context of overall government spending of $3.7 trillion or so per year, it isn't. Most estimates have the extraordinary measures only lasting till September or October at which point a default event may occur, unless Congress raises the ceiling.

Not on the official list of measures for finessing the debt ceiling is a rarely-mentioned option that I like to call the gold trick. The U.S. government owns a lot of gold. Beware here, because a few commentators think that the idea behind the gold trick is to sell off some of this gold in order to fund the government. Nope—not an ounce of gold needs to be sold. The only thing that the Treasury need do is raise the U.S.'s official price for gold. By doing so, it automatically gets "free" funding from the Federal Reserve, funding which doesn't count against the debt ceiling.

We need a bit of history to understand the gold trick. Back in 1933 all U.S. citizens were required to sell their gold, gold certificates, and gold coins to the Fed at a rate of $20.67 per ounce. This is the famous gold confiscation that gold bugs like to talk about (see picture at top). The 195 million ounces that the Fed accumulated was subsequently sold to the Treasury. In return, the Treasury provided the Fed with gold certificates obliging the Treasury to pay them back. At the official price of $20.67, these certificates were held on the Fed's books at $4 billion.

The certificates the Fed received were a bit strange. A gold certificate usually provides its owner with a claim on a fixed quantity of gold, say one ounce, or 1/2 an ounce. In this case, the certificates provided a claim on a nominal, not fixed, amount of gold. If the Fed wanted to redeem all its certificates, it couldn't ask the Treasury for the 195 million ounces back. Rather, the certificates only entitled the Fed to redeem $4 billion worth of gold at the official price.

As long as the yellow metal's price stayed at $20.67, this wasn't a big deal. But it had important consequences when the official gold price was changed, which was exactly what happened in January 1934 when President Roosevelt increased the metal's price from $20.67 to $35. At this new price, the stash of gold held at the Treasury was now worth $6.8 billion, up from $4 billion. But thanks to their odd structure, the value of the Fed's gold certificates did not adjust in line with the revaluation—after all, they offered little more than a constant claim on $4 billion worth of gold. The remaining $2.8 billion worth of gold, which had been the Fed's just a month before, was now property of the Treasury.

Almost immediately the Treasury printed $2.8 billion worth of fresh gold certificates, shipped these certificates to the Fed, and had the Fed issue it $2.8 billion in new money. Voila, the Treasury had suddenly increased its bank account, and it didn't even have to issue new bonds, raise taxes, or reduce program spending. All it did was change the official gold price.

Even when the U.S. eventually went off the gold standard—unofficially in 1968 and officially in 1971—it still maintained the practice of setting an official gold price. But by then the official price was no longer the axis around which the entire monetary system turned; it was little more than an accounting unit.

As gold's famous 1970s bull market started to ramp up, the authorities tried to keep pace by enacting changes to the official price. When gold hit $55 in May 1972, the official price was bumped up from $35 to $38. They ratcheted it up again in February 1973 to $42.22, although by then gold's market price had advanced to $75. Both of these revaluations resulted in the Fed providing new money to the Treasury, just like in 1934. Albert Berger, a Fed economist, has a good description of these two events:

After the 1973 revaluation the government stopped trying to keep up to gold's parabolic rise, and to this day the U.S. maintains an archaic price of $42.22, far below the actual price of $1250 or so.

---

Let's bring this back to the present. Come October, imagine that the U.S. Treasury has expended all of its conventional extraordinary measures and Congress—despite having a Republican majority—can't decide on increasing the debt ceiling. Desperate for the cash required to keep basic service open, Treasury Secretary Mnuchin turns to an archaic, long forgotten lever, the official gold price. Maybe he decides to change it from $42.22 to, say, $50, or $100, or $1000—whatever amount he needs in order to fund the government. The mechanics would work exactly like they did in 1934, 1972, and 1973. The capital gain arising from a rise in the accounting price would be credited to the Treasury in the form of new central bank deposits, and these could be immediately deployed to keep the government running.

Any change in the official price of gold needs to be authorized by Congress. Why would the same Congress that can't agree on adjusting the debt ceiling or repealing Obamacare agree to Mnuchin's request to change the price of gold? The Republican party has a long history of advocating for the gold standard; Ronald Reagan, for instance, was a supporter. President Trump himself likes the yellow metal. If you believe him, he once made a lot of money off of it:

As for the Republican's base, many of them are keen on ending the Fed—anything that smells of a return to gold will make them happy. This seems to be a piece of legislation that pleases all factions.

The gold trick only works because the debt issued by the Fed—reserves, or deposits—is not included in the category of debts used to define the debt ceiling. By outsourcing the task of financing government services to the Fed via gold price increases, the Treasury can sneak around the ceiling. This is only cosmetic, of course, because a debt incurred by the Fed is just as real as a debt incurred by the Treasury, and so it should probably be included in the debt ceiling. After all, the taxpayer is ultimately on the hook for debt issued by both bodies.

An increase in the price of gold to its current market price of $1250 would only be a band-aid. While it would provide the Treasury with around $315 billion in new funds from the Fed, this would be enough to evade the debt ceiling for just a few months, maybe half a year. Sure, a few well-time Donald Trump tweets about the greatness of gold might push the price up by $50 to $1300, but even that would only buy the Treasury an extra $13 billion or so in central bank funds.

---

The Fed would hate the gold trick.

Much of Fed policy over the last few years has involved communicating with the public about the future size of the Fed balance sheet, which shot up over three rounds of quantitative easing. A sudden $315 billion increase in liabilities outstanding due to a revaluation of the official gold price to $1250 would throw a wrench in this strategy. To the public, it would look QE4-ish.

QE is reversible. Unlike QE, the Fed would not be capable of reversing a balance sheet expansion caused by a gold revaluation, at least not without the Treasury's help. This would severely damage the Fed's independence. To see why, keep in mind that the Fed can only ever increase the money supply if it gets an asset—a bond, mortgage backed securities, gold, etc—in return. The advantage of having an actual asset in the vault is that it can be sold off in the future should a constriction in the money supply be necessary. Assets also generate income which can be used to pay the Fed's expenses like salaries or interest on reserves. With the gold trick, however, the Fed is being asked to increase the money supply without receiving a compensating asset. This means that, should it be necessary to drastically shrink the money supply in the future, it will only be able to do so by relying on goodwill of the Treasury. So much for being able to act independently of the President.

That the Fed probably prefers that the Treasury avoid a gold revaluation is one reason that it has never become one of the go-to extraordinary measures for finessing the debt ceiling. But I'm not sure that the current administration is one that cares very deeply about what the Fed thinks. If Congress greenlights the revaluation, there's really nothing that Fed Chair Yellen can do except enter-key new money for Mnuchin.

---

Earlier I mentioned that adjusting the official price to $1250 would only be a band-aid solution. Here's a bit of speculative fiction: imagine that come October the official price is adjusted up to something like $2000, or $5000, or $10,000. Granted, this would put it far above the market price of $1250--but the official price has been wrong for something like fifty years now; does anyone really care if the error is now to the upside rather than the downside?

At an official price of $10,000, for instance, the Treasury would get some $2.6 trillion in spending power from the Fed, enough for it to avoid issuing new t-bills and bond in excess of the debt ceiling for several years. The Republicans would save face; they could tell their constituents that they held firm against an increase in the ceiling. When the Democrats--who are no friends of gold--inevitably come back to power, they could simply go back to the tradition of jacking up the debt ceiling.

This would certainly be a strange world. During Republican administrations, bond and bill issuance would slow dramatically, reserves at the Fed expanding in their place. Like the various QEs, there is no reason that these reserve expansion would cause inflation. The Fed would have to be careful that it pays enough interest on reserves that banks prefer to hoard their reserves rather than sell them. This increase in the Fed's interest burden would dramatically crimp its profits, which are paid out as a dividend to the Treasury each year. In fact, all the money the Treasury saved on not paying t-bill and bond interest would be almost precisely cancelled out by a shrinking Fed dividend. There is not much of a free lunch to be had.

Investor who like to hold government debt in their portfolios would be in a bit of a jam. Everyone can buy a t-bill, but the ability to hold reserves is limited to banks. Unless the Fed were to allow wider access to their balance sheet, Republican administrations resorting to the gold trick would create broad safe asset shortages.

While a small increase in the official gold price may be part of Mnuchin's backup plan, a large increase to the official gold price is just speculative fiction. After all, a boost in the official price of gold to $10,000 would create an entirely different monetary system. Alternative systems are certainly worth exploring for what they teach us about are own system, but one would hope that the actual adoption of one would come after long debate and not as a result of opportunistic politics.

P.S. After writing this post, I stumbled on a paper by Fed economist Kenneth Garbade which describes how Eisenhower finessed the debt ceiling by using a version of the gold trick. Unlike 1972 and '73 the gold price was not increased. Instead, the Treasury was able to make use of unused space from the 1934 revaluation. A large portion of the gold the Treasury owned had not yet been monetized by writing up gold certificates and depositing them at the Fed. In late 1953, with the debt ceiling biting, around $500 million in gold certificates were exchanged with the Fed for deposits.

Friday, July 21, 2017

Nick Rowe points out that if a central bank wants to control the economy's price level, it needn't issue any actual money—it can just edit the dictionary every morning, announcing the meaning of the word "dollar" or "yen" or "pound" to the public.

To a modern ear trained on a steady diet of central bank verbiage about interest rates, QE, and open market operations, the idea of conducting monetary policy by simply editing the meaning of a word seems odd. But I've got news for you: starting from Caesar's time and extending into the 1700s, the sort of dictionary money that Nick describes has been the dominant form of money in the West.

How has this system worked? People have historically advertised prices for wares using a word, or unit of account, the LSD unit being the most prevalent. In the case of Britain this meant pound/shilling/pence while in France it was livre/sous/denier, both of which come from the Latin librae/solidi/denarii. The monarch was responsible for declaring what these words meant. More specifically, the king or queen would post a sign in some central area saying something to the effect that a pound, or £, was worth, say, ten testoons, a type of silver coin. This definition was subject to change. The next day, for instance, an edict might be issued saying that a £ was now only worth nine testoons. Or, put differently, the £ now contained less silver. Just like that, prices had to rise 10% to account for the alteration made to the dictionary meaning of the word "pound."

Dictionary systems came to an end when the symbol for money was finally fused directly with the instrument itself. Remember, coins never used to have denominations, or units of account, on their face. Rather, they usually only had the monarch's head inscribed on them, maybe the name of the mint, and a few words about how awesome the monarch was. This lack of numbering was convenient. Since coins had no association with the unit of account, the quantity of coins (and thus silver) in the unit of account (i.e. the definition of the word) could be seamlessly changed by royal proclamation.

In the 1700s monarchs began to adopt the practice of inscribing the actual unit of account directly on the coin's face, i.e. coins began to be etched with 5¢ or £0.5.* Once this happened it became awkward to change the definition of the unit of account by editing the dictionary. Having permanently stamped the meaning of the word "dollar" or "pound" on millions of widely-circulating bits of stamped silver, changing that meaning by simply posting a sign on a popular street corner no longer did the trick. Every coin would have to be recalled and re-minted too!

Having long since put the definition of the word "dollar" or "yen" onto the actual instruments they issue, modern monetary authorities now have to do something to the instruments themselves if they want to conduct monetary policy. Maybe they issue a few more units of money or buy them back in order to alter their purchasing power. Maybe they jiggle the interest rate that those tokens throw off. Or they might raise or lower a currency's peg. Some sort of tangible action (or threat thereof) must be taken to change the economy-wide price level. Word updates won't do.

About the only place in the world that has dictionary money is Chile which, buffeted by high inflation, adopted a parallel unit of account called the Unidad de Fomento (UF) in the 1960s. (For more on the UF, see my old post here). Today, Chileans can choose to set prices in UF or in the Chilean peso. The latter is a conventional money, the word "peso" being defined as the 1 peso banknote issued by the nation's central bank. Unlike the peso, the UF lacks an underlying UF banknote. Rather, the Chilean government defines the word "Unidad de Fomento" to mean the number of Chilean pesos required to buy a fixed Chilean consumption basket. This definition changes every day and is posted here.

I think this is a pretty neat idea. As long as Chileans denominate their salary and other contracts using UFs rather than pesos, they are guaranteed to earn a steady stream of consumption, even if the Chilean peso hyperinflates.

These days inflation isn't really such a big deal, at least not in developed nations—central bankers seem to have mastered how to keep the purchasing power of the medium of exchange from getting out of hand. So adopting something like the UF might seem redundant. A dictionary money system is also unattractive because it imposes a calculational burden on citizens. People must be constantly doing conversions between an item's sticker price and whatever happens to be the medium of exchange necessary to complete the transaction. So if a book were to be priced at $5, you'd have to consult a government website to determine how many bitcoins, or dollar bills, or silver coins would be necessary to constitute a five dollar payment. The advantage of our current system is that because the word and the medium are unified, we don't have to do these conversions. A five dollar bill always suffices to cover a $5 sticker price. Simple.

On the other hand, dictionary money may have a role to play in our relatively recent deflationary age. Beginning with Japan back in the late 1990s, central bankers all over the world have been incapable of preventing deflation, or falling prices. Are their tools inadequate? Do they refuse to use these tools to their full extent? Do they not understand how to use them? With dictionary money, a central banker can't blame his or her tools for a miss, since all it takes to alter the price level is an update to the definition. A child could do it.

For instance, a nation like Japan could create dictionary money by removing the word "yen" on bills. It would do so by recalling all outstanding banknotes and replacing them with, say, Japanese pesos. Prices, however, would continue to be set in terms of the yen unit of account. Each morning the Bank of Japan would announce to the world how many Japanese pesos were in a yen. Say it starts with the yen being defined as ten pesos. To create some inflation, it would simply proclaim that the yen now contained just five pesos. Everyone with pesos in their pocket would suddenly be able to buy twice as much yen-denominated products as before. They would race out and spend. Shopkeepers who had previously been selling widgets for 1 yen, and getting ten Japanese pesos as payment, would quickly jack up prices to 2 yen in order to ensure that they still earn ten pesos per widget.

Wednesday, July 12, 2017

Most of the world's money is currently in the form of deposits created by banks. After the 2008 credit crisis, which instilled a strong suspicion of banks among the public, it became fashionable to ask what money would look like in an economy without these organizations. Burn them to the ground or shutter them, what would take their place? One vision is to pursue pure centralization: have the state monopolize all money creation, say by providing universally-available accounts at the nation's central bank. Positive Money is an example of this. Another alternative, by way of Satoshi Nakamoto, is to pursue radical decentralization: replace bank IOUs with digital commodity money in the form of bitcoin and other private cryptocoins.

I'm going to provide a few historical examples that sketch out a third option for replacing banks; bills of exchange. A system underpinned by bills of exchange is capable of converting illiquid personal IOUs into money using a distributed method of credit verification, as opposed to a centralized method patched through a banking organization. Unlike bitcoin, however, these are IOUs, not mere bits of digital ledger-space. While few people these days are familiar with the bill of exchange, in its hey day this instrument was responsible for executing a large chunk of the Western world's transactions.

---

The first story is of cheques, an instrument that while not precisely a bill of exchange gets pretty close. Last week in my homage to the cheque I brought up the Irish bank strike of 1970, described by Antoin Murphy (from whom I steal the title of this blog post). When the nation's banks shuttered their windows for half the year, Irish citizens re-purposed uncleared cheques as personal IOUs, these cheques circulating as a cash substitute. The system was decentralized in that banking institutions no longer served as creators of the medium for making payments; instead, everyone became their own unique money issuer. As Tim Harford recently wrote, pubs and corner shops were able to vouch for the creditworthiness (or not) of each cheque.

Irish cheque money only circulated for six months. After the banks reopened in November 1970, mounds of cheques were cleared & settled and the system returned to normal. Luckily, we have historical examples that lasted much longer than this.

---

Let's go back in time to Antwerp in the late 1400s. The institution of banking had been present in Europe for a few centuries, but accordingto Meir Kohn (who I get much of this material from) it began to go into decline at the end of the 15th century as waves of bank failures broke out across the continent, due in part to coin shortages. In Antwerp, the authorities went so far as to ban the practice of banking in 1489. In lieu of bank deposits, coins could of course be used to make payments, but this would have been a step backward since deposit banking had emerged, in part, to solve the problems related to coins, specifically the fact that they are expensive to store, awkward to transport, and heterogeneous, some coins containing more precious metals than others.

Similar to the Irish five hundred years later, Antwerp's financiers adapted to the death of bank money by innovating a decentralized alternative. Where the Irish chose cheques as their payments instrument, Antwerp settled on a related paper-based order called the bill of exchange. A bill of exchange was a popular way to remit money in medieval times. Say you were a citizen of Florence and you needed to get 20 gold coins to a relative in Venice. Rather than incur the cost and danger of transporting the coins yourself, you might try and strike a deal with a merchant who had offices—and gold—in both cities. By paying the merchant some gold in Florence, your home city, he would issue you a bill of exchange. This bill ordered his colleague in Venice to pay out 20 gold coins to whoever happened to be the bill bearer. You'd then send the bill to your relative in Venice, and he'd bring it into the office and collect the money. The merchant would earn a commission on the deal. No actual gold would travel between the two cities, just a secure and light paper instrument. It was a fantastic technology for saving on the costs of shipping and handling heavy coins.

While bills of exchange started out as remittance instruments, they were later used by merchants as a form of credit. A merchant might want to sell some wool to a manufacturer who in turn required three months to convert the wool into cloth and sell it. To finance the purchase of wool, the manufacturer could always turn to a banker. Absent a banker, the merchant himself might provide the manufacturer with a loan by drawing up a bill of exchange. On its face this bill contained written instructions ordering the manufacturer to pay x coins three months hence to the bearer of the bill. The merchant would keep it in his desk, and when the requisite amount of time had passed he would bring the bill to the manufacturer and collect on his debt, earning interest in the meantime.

The common denominator of a bill of exchange, whether used as a remittance or as credit, is that a private citizen has issued their own personal IOU, to be redeemed for cash after some time has passed. Then Antwerp happened.

In its original form, a bill of exchange could only be used by a small group of people, the initial drawer of the bill, the payor, and the payee. Antwerp's financiers took the bill of exchange and converted it into a fully transferable instrument, or money. They pried open the closed circuit so that if merchant A owned a bill of exchange that was to be paid out in coin by merchant B next month, merchant A could in the meantime transfer this IOU to merchant C as payment, and merchant C could transfer it to merchant D, and D to E etc. These transfers, or assignments, could occur without asking the original debtor, merchant B, for permission. This would have dramatically increased the liquidity of bills of exchange, allowing them to fill the vacuum left in Antwerp by the banning of bank deposits,

To further protect anyone who received a bill of exchange in payment, Kohn tells us that these instruments were granted currency status by Antwerp's merchants. As I wrote here, this meant that even if the bill of exchange had been stolen from merchant B and paid to merchant C (who had innocently accepted it), merchant B could not sue merchant C to get the bill back. This legal upgrade would have further promoted the liquidity of bills of exchange, since merchants needn't bother setting up burdensome verification processes to ensure that bills of exchange presented to them were not stolen. In the eyes of merchant law, all bills of exchange were considered "clean."

There was still one last barrier to creating a truly decentralized medium of exchange; how to overcome stranger danger. Say that you and I are acquaintances and I owe you $20. I tell you I'm going to settle my debt by giving you an IOU issued by another party. Banks are a great way to solve the stranger problem, since everyone will agree to settle debts using the IOUs of a well-known and trusted intermediary like a bank. But say instead I offer you a $20 bill of exchange that I've received from a friend. If you know that person you'll probably accept the deal, but in an economy like Antwerp's with thousands and thousands of actors, you might not know the name of the debtor written on the bill. And without enough knowledge to accept the credit, you'd have probably refused it.

According to Kohn, the final innovation developed in Antwerp solved the stranger problem—the ability to endorse a bill of exchange. I simply signed my name to the back of $20 bill of exchange, or endorsed it, and handed it to you. By signing it, I was agreeing to accept the debt as my own. So if the original debtor failed to pay you for the bill when it came due, you could flip the bill over and pursue the first name on the list of endorsees—me—for payment. And since you knew and trusted me, it was now possible for you to evaluate the credibility of a $20 bill of exchange that had originally been issued by a stranger. Bills could in turn be re-endorsed on by others, a long chain of transactions being made before the bill finally expired. Indeed, Henry Dunning Macleod once remarked that bills might sometimes have "150 indorsements on them before they became due."

From Antwerp, the practice of using negotiable bill of exchange would spread to the rest of Europe, in particular Britain. Below is an example of a bill of exchange from 1815 that ordered Pickford's, an English canal company, to pay £72 11s 1d to Richard Vann. You can see first hand how the stranger problem is solved. The bill has multiple endorsements on its reverse side (pictured below), including that of Richard Vann, William Alcock, T S Marriott, William Whittles, Jones & Mann, Thomas Whalley & Sons, James Mitchell and Richard Williams. To see the front side of the bill, click through to the original link:

Not only did this chain of cosigning individuals solve the stranger problem. It also created an incredibly safe instrument. Bills of exchange were effectively secured not only by the original person whose name was inscribed on the front, Vann, but by all the others who had cosigned the back; Alcock, Marriott, Whittles, etc. The odds of everyone on the list failing would have been quite low. It was an ingenious system.

---

Another interesting anecdote on bills of exchange comes from the county of Lancashire in north west England in the 1800s. By then, banknotes had long since been invented and were a popular payments medium in England. Typically issued by small private "country banks," banknotes were a centralized payments technology insofar as their value depended on the good credit of one issuer, the bank. Inhabitants of Lancashire were particularly suspicious of these instruments which explains why there were almost no note-issuing banks in the county. T.S. Ashton speculates that this wariness was due to the 1788 failure of Blackburn-based Livesay, Hargreaves and Co, a banknote issuer: "generations after, when proposals were made for local notes, men's minds turned back to the events of 1788."

In the absence of a system of banks providing transferable deposits or notes, bill of exchange circulated in Lancashire, even dominated, so much so that they were often "covered with endorsements" and become famous for their dirty appearance. Indeed as late as the 1820s, Ashton tells us that some "nine-tenths of the business of Manchester was done in bills, and only one-tenth in gold or Bank of England paper." Bills were used even in small denominations, say to pay piece workers. This is surprising because bills of exchange had typically been used by merchants and wholesalers, and therefore tended to be issued in large denominations.

Alas, according to Ashton the Lancashire bill of exchange was done in by the increase in stamp duties, which effectively made it more cost-effective to use bank-issued forms of payment that didn't require a stamp.

---

Just a few random thoughts in closing.

While Ireland, Lancashire, and Antwerp all provide a sketch of an alternative, distributed form of converting personal IOUs into money, do we really need a replacement for banks? While the U.S. banking system certainly had its difficulties in 2008, Canadian banks skated smoothly through the crisis. Maybe banks only need a face lift.

Even if we need to burn the suckers down, a paper-based backup like bills of exchange or cheque just won't cut it—we need digital money. But is it possible to digitally replicate the features of a bill of exchange? And even if an online bills of exchange system could be built, we live in an age where money transmitting is a highly regulated industry—how legal would it be for individuals to take over the role of money creator, transmitter, and verifier? (I once thought that Ripple was the answer to digitally replicating bills of exchange. But they decided to serve banks instead. Maybe Trustlines fits the *ahem* bill?)